Morningstar's head of alternatives research Nadia Papagiannis describes the flavors of long-short equity funds, which can hedge investors' equity risk exposure, along with three funds that top her watch list.

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Avoiding Psychological Traps When Investing in Alternatives

Most investors strive to make rational investment decisions, but in reality, emotions often drive behavior. Whether it’s a tendency to stick with the familiar, an inclination to follow the crowd, or a blinding sense of overconfidence, emotionally driven decision-making can have devastating effects on our portfolios. Because alternative funds in particular are new to many investors, the consequences of developing bad habits in this part of the asset allocation can be especially costly. Fortunately, though, as irrational as these psychological investing traps may appear, they can in fact be predicted and avoided. In the long-run, an investor's portfolio will be all the stronger for it.

Familiarity Bias Leads to Apprehension
Familiarity breeds comfort. We see investors time and again flock to recognizable names and investments rather than pragmatically analyzing expected risk and return. This inclination to invest in the things we know often leads to poor diversification. For example, most investors and their advisors are comfortable with the "traditional" portfolio weighted (by dollars) 60% in stocks and 40% in bonds as a prudent method of diversification. Yet over the last 20 years, a 60/40 portfolio more closely resembled a 90/10 portfolio, since 90% of the risk stemmed from equities. Being overexposed to equities and underestimating overall portfolio risk led to large losses (about 35%, using the S&P 500 and the BarCap US Aggregate Bond Indexes as proxies), which have still not been recouped (though Sept. 30, 2011).

Alternatives, as exotic as they may seem, can add real diversification to a portfolio. Allocating 20% to the average market-neutral fund, for example, from the equity portion of a standard 60/40 portfolio, would have improved an investor's risk-adjusted return (as measured by the Sharpe ratio) over a three-year, five-year, 10-year, and 15-year period (through Sept. 30, 2011) because of these funds' near-zero correlation to stocks plus a positive long-term returns. Adding one of the better market-neutral funds, such as Arbitrage Fund ARBFX, would have had an even greater positive impact on a traditional portfolio. Of course, if an investor cannot understand a strategy or process, he won't be able to effectively evaluate its merits and select the right one. But there are plenty of knowledgeable advisors out there who can provide additional education and guidance regarding these strategies.

Some advisors, though, suffer from the same behavioral tendencies that plague their clients. The Morningstar's 2010 Alternative Investments Survey conducted with Barron's, for example, found that 48% of the advisors surveyed believed that lack of understanding remained a significant barrier to investing in alternatives. This hesitancy can be explained in part by the nascency of the liquid alternatives industry--nearly half of all 250 or so alternative mutual funds launched post-2008. Before this proliferation, most alternative strategies were accessible to only the top rung of an advisor's clientele through hedge funds. Furthermore, many of these new products have been launched by smaller, niche shops, with less-entrenched names and reputations, giving advisors even more pause.

Investors should bear in mind, though, that many of these seemingly new alternative strategies were run in a hedge fund or separately managed account prior to their mutual fund launch. And even though investors naturally take comfort in highly recognizable asset managers, such as T. Rowe Price or Vanguard that have received topnotch Stewardship Grades for their commitment to shareholders, there are lesser-known alternative fund managers, such as Hussman Econometrics Advisors Inc. and TFS Capital LLC that also exhibit shareholder-friendliness. Both carefully monitor transaction costs, and neither charges a 12b-1 fee.

Herding Behavior and Asset-Allocation Conundrums
Kudos goes to those investors who have already accepted alternatives, despite their relative obscurity. The next step is to create an appropriate asset allocation, a process that can be difficult for those accustomed to simply following the crowd. Prior to 2008, investors following the traditional 60/40 model were clearly overexposed to equities, and post-2008, investors herded into fixed-income mutual funds ($688 billion of inflows through Sept. 30, 2011). This is probably not prudent, considering interest rates are likely to rise in the future.

When trying to incorporate alternatives and unconventional asset class into their portfolios, many investors are left scratching their heads. First, there's a benchmarking problem. How does one even go about modeling an asset allocation with alternatives? Next, investors must decide how much to allocate, and where to allocate from.

Though benchmarks are tricky for alternatives investments, they do exist. For example, long-short equity strategies may not be as volatile as long-only stock funds but remain highly correlated to stocks: Using monthly data through September 2011, the category's 10-year correlation to the S&P 500 is 0.95. Therefore, benchmarks such as the S&P 500 are still appropriate. One must consider, however, a fund's outperformance relative to the beta, or level of stock-market risk, it takes on. In contrast, market-neutral funds hedge out virtually all equity-market exposure, and therefore should add value above a cash benchmark (three-month Treasury bills, for example). Currency funds are by and large bets against the U.S. dollar, and therefore can be compared to a short-U.S. dollar benchmark such as PowerShares DB US Dollar Index Bearish UDN. These benchmarks, while far from perfect, can help advisors and investors better allocate their portfolios.